Bank and Non-Bank Financial Intermediation

Conglomerates, trade credit arrangements and banks are all instances of financial intermediation. However, in spite of this fundamental similarity, important differences exist between these institutions. In particular, they differ in the extent to which the projects financed absorb aggregate intermediary risk, in whether or not intermediation is carried out by a financial specialist, in the type of projects they fund and in the type of claims they issue to investors. The paper develops a simple unified model that both accounts for the continued co-existence of these different forms of intermediation, and explains why they differ. Specific applications to conglomerate firms, trade credit and banking are discussed. ∗Kellogg School of Management, Department of Finance, Northwestern University, 2001 Sheridan Road, Evanston IL 60208-2001. I thank seminar audiences at the AFE and Gerzensee, Douglas Diamond, Michael Fishman, Arvind Krishnamurthy, Philip Strahan, Robert Townsend and especially Richard Green (editor) and an anonymous referee for some very helpful comments. I am grateful to the Institute for Advanced Study for hospitality and financial support (in conjunction with Deutsche Bank) over the academic year 2002-03. Any remaining errors are of course my own. Conglomerates, trade credit arrangements, and banks are all instances of financial intermediation. In each case, the conglomerate headquarters/supplier/bank obtains funds by selling financial securities, while in turn providing funds in exchange for a claim on project cash flows.1 However, in spite of the fundamental similarity between these forms of financial intermediation, important differences exist between them. In particular: (I) What happens to project financing when the financial intermediary as a whole performs badly? Projects financed by conglomerates are adversely affected, in the sense that resources available to each division for investment are curtailed.2 On the other hand, large bank borrowers are not much affected by a decline in the fortunes of their lending bank.3 (II) Who performs the intermediation function? Both in the case of conglomerates and trade credit, intermediation is carried out in conjunction with real economic activity. Historically at least some commercial banks have also fitted this pattern.4 In contrast, modern commercial banks are run by financial specialists. (III) What types of project does an intermediary finance? On the one hand, commercial banks finance only relatively low risk projects (or at least the low risk component of cash flows). This is not the case for conglomerates. (IV) What sort of liabilities does a financial intermediary issue to fund itself? Different types of financial intermediary issue different mixes of financial securities: a large fraction of the claims issued by commercial banks are very low risk, while this is not the case for conglomerates. In this paper I develop a unified model (based on a single friction) that explains how these four features of financial intermediation are linked. By doing so, I account for the continuing co-existence of different forms of intermediation. In the model, the viability of all forms of financial intermediation mentioned depends on the advantages stemming from diversification. At the same time, the model accounts for why, given this shared origin, the questions of how much aggregate intermediary risk the projects financed should absorb, and who should actually intermediate, are resolved so differently in different forms of intermediation.